Public distrust of bankers and financial markets has risen dramatically with the financial crisis. This column argues that this loss of trust in the financial system played a critical role in the collapse of economic activity that followed. To undo the damage, financial regulation needs to focus on restoring that trust.

They note:

Trust is crucial in many transactions and certainly in those involving financial exchanges. The massive drop in trust associated with this crisis will therefore have important implications for the future of financial markets. Data show that in the late 1970s, the percentage of people who reported having full trust in banks, brokers, mutual funds or the stock market was around 40%; it had sunk to around 30% just before the crisis hit, and collapsed to barely 5% afterwards. It is now even lower than the trust people have in other people (randomly selected of course).

In other words, people now trust bankers less than random people on the street.

They point out:

Trust was destroyed in large measure by the revelation of opportunistic behaviour that the crisis brought to light, of which the Bernard Madoff case is emblematic. Indeed, the data examined shows that in states where the number of Madoff victims was higher, the level of trust towards bankers, brokers and mutual funds has fallen more than in those states with a lower concentration of Madoff victims.

The dark light this has cast on the whole financial industry will most likely result in:

A drop in investment in risky assets, as such assets lend themselves more easily to opportunistic behaviour than simple securities. This will bias portfolios markedly towards safer securities and away from stocks.

A drop in demand for complex financial instruments with uncertain returns. Given that such instruments’ complexity exposes them more easily to fraud, a higher dose of trust is required for investors to hold them. If trust is absent, investors will turn to more familiar securities.

Turning to more familiar assets will increase the share of domestic assets in portfolios, making them somewhat less diversified. On the other hand, investors will tend to diversify their stable of intermediaries, in order to reduce their exposure to any one in particular. Both effects are costly, as the first entails losing the benefits of diversification and the second involves higher costs from setting and maintaining multiple relations.

A corollary of the above will be less reliance on and delegation to intermediaries, given that a fundamental ingredient in the intensity of financial delegation is the level of investor’s trust. Since delegation is more necessary the more sophisticated the security, this will also fuel a move towards simpler portfolios.

Lastly, since an insurance contract is also a financial contract, the fall in trust should also affect the demand for insurance.

In sum, the dearth of trust towards all segments of the financial industry will give rise to a generalised flight from financial trades, in particular from those more exposed to opportunistic behaviour.

The shift to safer assets will push up the equity premium, affecting the type of firms that depend on raising equity for their financing. If this preference also means that longer-maturity instruments will be shunned in favour of short-term ones, it will raise the cost of longer-term financing, hampering projects with longer maturities.

[A bank can be defined as a] third party whose record-keeping is trusted by all parties as recording the transfers of credit money that effect sales of commodities...

In a fundamental way, a bank is a bank because it is trusted. Of course, as we know from our current bitter experience, banks can damage that trust; but it remains the wellspring from which their existence arises.

Part of the reason that the campaign for people to move their money to smaller banks.

Given that the TBTFs have cooked their books every which way, it is not surprising that millions of Americans are moving their money to local banks and credit unions and campaigning for public banking.

For example, here is the search volume for the phrase "public banking" over the last 3 years:

Of course, banks could be untrustworthy in regards to some things - such as valuing their assets, keeping hundreds of billions of dollars worth of liabilities hidden in off-balance sheet sivs, using Repo 105s and other gimmicks to misrepresent their financial health, and doing things like pushing investments to their mom and pop clients while shorting those same investments - and yet be honest in processing normal depository transactions.

But most people are not going to trust a convicted house burglar to prepare their taxes, even though tax-preparation is different from physical burglary.

The distinguished international group of economists suggest various ways to restore trust in banks. But they miss the core truth: trust will not be restored unless the fraud is actually stopped.

But instead of trying to stop the fraud and prosecute the con artists who got us into this mess, Summers, Bernanke, Geithner and the rest of the boys are doing everything they can to cover it up and protect their buddies on Wall Street.

And in doing so, they are destroying the people's trust not only in Wall Street, but in the government, as well.

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